2021 Solution Exam 1

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Macroeconomics 1 – Examination 1 – PUC-Rio – 2021

Exercise 1 [3.5 points] Equilibrium with Complete Markets

a. The Arrow-Debreu equilibrium is a consumption allocation {{cit (st )}∞ t=0 }i=1,2
0 ∞
and a price system {qt }t=0 such that 1) given the price system, the allocation
solves each consumer’s problem;
P2 2) the allocation is feasible, ie it satisfies the
aggregate resource constraint i=1 ct (s ) ≤ 1 for all t and all st . [0.5 points]
i t

b. Consumer i maximizes utility subject to her budget constraint. The La-


grangian writes
∞ X
X ∞ X
X
i t
L = β ln[cit (st )] Prob(st ) + µi qt0 (st )[yti (st ) − cit (st )].
t=0 st t=0 st

The first-order condition for consumer i’s problem is


1
βt Prob(st ) = µi qt0 (st ) for all i, t, st . [0.5 points]
cit (st )
Combine the two FOCs of consumers 1 and 2 by substituting out the price
c1t (st ) µ2
2 t
= .
ct (s ) µ1
We see that the ratio of consumption allocations is constant. In addition, the
aggregate endowment is constant and equal to one. Thus, consumption of each
agent is also constant
c1t (st ) = c1 = 1 − c2 .
Using this, divide the FOC in time t by the FOC in time 0 and obtain an expres-
sion for the price or Arrow-Debreu securities, where q00 = 1 is the numeraire

qt0 (st ) = β t Prob(st |s0 ). [0.5 points]

Substitute these expressions in the budget constraint of consumer 1


∞ X
X ∞ X
X
qt0 (st )[yti (st ) − cit (st )] = β t Prob(st |s0 )[(1 − st ) − c1 ].
t=0 st t=0 st

Therefore,

c1 XX
= β t Prob(st |s0 )(1 − st )
1−β t=0 t s
or
" ∞
#  
1
X
t β 3−β
c = (1 − β) 1/2 + β (1/3 × 1 + 2/3 × 0) = (1 − β) 1/2 + = .
t=1
3(1 − β) 6
3+β
c2 = 1 − c1 = . [0.5 points]
6

1
c. From the previous question we deduce

lim c1 = 1/3 and lim c1 = 1/2.


β→1 β→0

lim c2 = 2/3 and lim c2 = 1/2.


β→1 β→0

In period 0, both consumers have an endowment of 0.5. Consumer 1’s consump-


tion is lower than her initial endowment, while consumer 2’s consumption is
higher. This means consumer 1 is buying more Arrow-Debreu securities in time
0 than she is selling, to insure against future income shocks, while consumer 2
is selling more than she is buying.
As β increases, the consumption of consumer 1 decreases and the consumption
of consumer 2 increases. Intuitively, as consumer 1 becomes more patient, she
values more the future, is more willing to insure against future uncertainty, and
thus wants to purchase more Arrow-Debreu securities. This pushes up the price
of the securities qt0 (st ) = β t Prob(st |s0 ), which incentives consumer 2 to be at the
other end of the deal and sell these securities.
Inversely, as β decreases, agents are less patient and are less willing to reduce
their consumption today to insure against tomorrow. Ironically, consumer 1 con-
sumes more when she is impatient, because she gets a better deal on the price
of Arrow-Debreu securities. In this economy (and in the real world?), patience
creates inequality. [0.5 points]

d. Financial wealth in time 1 and state 1 is given by


∞  
X
t 3−β 3+β β
Y1 = β −1 =− < 0. [0.5 points]
t=1
6 6 1−β
∞  
X
t 3+β 3+β β
Y2 = β −0 = > 0.
t=1
6 6 1 − β

Consumer 1 enters period 1 with negative financial wealth. This means she
owes to consumer 2. She is lucky to have landed in a good state, but must now
deliver the goods she promised in period 0, at the time when the world was un-
certain and she was eager to buy securities to insure against the future. Given
that her wealth is negative, she cannot buy more claims to future consumption
without giving up on consumption in other periods, thus harming her perfectly
smoothed consumption plan. Therefore, even if markets reopened, it would not
be in her interest to trade. [0.5 points]

Exercise 2 [4 points] Neoclassical Growth

a. The household maximizes utility subject to the resource constraint and the
capital accumulation equation. Combine the two constraints

Ct = (1 + r)Kt + zt − Kt+1 .

2
Let K̃ and z̃ be the value of capital and productivity tomorrow. Plug the resource
constraint into the utility function and write a Bellman equation [0.5 points]
 h i2 
V (K, z) = max (1 + r)K + z − K̃ − λ (1 + r)K + z − K̃ + βEV (K̃, z̃) .

b. The first-order condition with respect to K̃ and the envelope theorem are

− 1 + 2λC + βEV 0 (K̃) = 0.


V 0 (K) = (1 + r)(1 − 2λC). [0.5 points]

Combine the two necessary conditions and obtain the Euler equation

1 − 2λCt = β(1 + r)(1 − 2λEt Ct+1 ).

Since r = β −1 − 1, the equation boils down to 1 − 2λCt = 1 − 2λEt Ct+1 or

Ct = Et Ct+1 . [0.5 points]

Consumption follows a random walk. The expected value of consumption to-


morrow is simply equal to the realization of consumption today. [0.5 points]
c. We guess that consumption takes the form Ct = A+BKt +Dzt . Substitute this
equation and the production function into the capital accumulation equation

Kt+1 = −A + (1 + r − B)Kt + (1 − D)zt . [0.5 points]

d. Rewrite the Euler equation using the guess

A + BKt + Dzt = Et [A + BKt+1 + Dzt+1 ].

Combine the previous two equations

A + BKt + Dzt = A + BEt [−A + (1 + r − B)Kt + (1 − D)zt ] + DEt zt+1 .

Since Et zt+1 = Et [ρzt + εt ] = ρzt , we can simplify

A + BKt + Dzt = A(1 − B) + B(1 + r − B)Kt + [B + D(ρ − B)]zt .

In order for this equation to hold, we need the coefficients on Kt and zt and the
constant term to be the same on both sides. Equating the coefficients on Kt
yields
B = B(1 + r − B) or B = r.
Equating the coefficients on zt yields
B
D = B + D(ρ − B) or D= .
1−ρ+B

Equating the constant terms yields

A = A(1 − B).

3
Provided that B = r 6= 1, we need A = 0. We are ignoring the case where B = 0
and D = 0 with no restriction on A. [0.5 points]
r
e. Substituting B = r, D = 1−ρ+r , and A = 0 into the guess for consumption and
the capital accumulation equation yields
r
Ct = rKt + zt .
1−ρ+r
1−ρ
Kt+1 = Kt + zt . [0.5 points]
1−ρ+r
Suppose with no loss of generality that εt = zt = 0 before the shock hits. In
period t, there is a one-time positive realization of εt = 1 − ρ + r. From period
t + 1 onward, εt = 0 again.
Capital Kt is predetermined and hence is not affected. The change in output in
period t is
∆Yt = r∆Kt + ∆zt = 0 + (1 − ρ + r).
The change in consumption in period t is given by
r r
∆Ct = r∆Kt + ∆zt = 0 + (1 − ρ + r) = r.
1−ρ+r 1−ρ+r
In period t + 1, εt+1 = 0, but zt+1 is not zero due to the autoregressive term

∆zt+1 = ρ∆zt = ρ(1 − ρ + r).

The change in the capital stock is given by


1−ρ 1−ρ
∆Kt+1 = r∆Kt + ∆zt = 0 + (1 − ρ + r) = 1 − ρ.
1 − ρ + rt 1−ρ+r
Intuitively, the output rise of 1 − ρ + r units is split into r units of consumption
and 1−ρ units of investment, ie capital (we assume no depreciation). The change
in output in t + 1 is

∆Yt+1 = r∆Kt+1 + ∆zt+1 = r(1 − ρ) + ρ(1 − ρ + r) = r + ρ(1 − ρ).

The change in consumption is


r r
∆Ct+1 = r∆Kt+1 + ∆zt+1 = r(1 − ρ) + ρ(1 − ρ + r) = r.
1−ρ+r 1−ρ+r
Thus there are no further dynamics for consumption. It remains higher than
its initial level by the amount r.
Similarly, we can calculate these changes for period t + 2

∆zt+2 = ρ∆zt+1 = ρ2 (1 − ρ + r).


1−ρ (1 − ρ)ρ(1 − ρ + r)
∆Kt+2 = ∆Kt+1 + ∆zt+1 = (1 − ρ) + = 1 − ρ2 .
1−ρ+r 1−ρ+r
∆Yt+2 = r∆Kt+2 + ∆zt+2 = r(1 − ρ) + rρ(1 − ρ) + ρ2 (1 − ρ + r) = r + ρ2 (1 − ρ).
r r
∆Ct+2 = r∆Kt+2 + ∆zt+2 = r(1 − ρ)2 + ρ2 (1 − ρ + r) = r.
1−ρ+r 1−ρ+r

4
We can now infer the patern. Following the one-time shock, consumption rises
by r and stays at this new level for ever. In addition, n periods after the shock
the change in output is
∆Yt+n = r + ρn (1 − ρ),
and the change in the capital stock is

∆Kt+n = (1 − ρ)n .

The dynamics of output and capital depend on the persistence ρ of the tech-
nology shock. In the special case where ρ = 0, ie no persistence, there are no
further dynamics after period t + 1. In the period after the shock, and in all
those thereafter, capital is higher by one and and output is higher by r. [0.5
points]

Exercise 3 [2.5 points] Demand Shocks and Real Business Cycles

a. The variable ξt multiplies the entire flow utility function of households.


Therefore, it can be interpreted as a preference shock, a taste shock, or a shock
to the discount factor. It can also be interpreted as a demand shock, since an in-
crease in νt shifts the marginal utility of consumption up and therefore results
in households demanding more consumption goods. [0.5 points]
b. An increase in ξt increases both the marginal utility of consumption and
the marginal utility of leisure (or equivalently, the marginal disutility of work).
Households want to consume more and work less at the same time. Thus, con-
sumption goes up and hours worked go down. With less labor, there is relatively
too much capital in the economy, and thus the wage goes up and the return to
capital goes down. This pushes investment down. Equivalently, more consump-
tion and less work means households must dissave to pay for the binge. As
hours and capital fall, output falls. Thus, the positive demand shock increases
consumption but leads to a recession: output, hours, and investment decrease.
[1 point]
b. No, these effects are not consistent with actual business cycles. Business cy-
cles are characterized by strong and positive comovements among output, con-
sumption, investment, and employment, ie hours worked. Demand shocks in
the RBC model lead to countercyclical consumption. [0.5 points]

c. In the RBC model, everything is driven by supply. Households want to con-


sume more, but a lower labor supply leads to lower production. If the model fea-
tured imperfection in goods or labor markets, resulting in rigid prices or rigid
wages, than the increase in demand for goods would also increase the demand
for labor. With sufficiently large rigidity, potentially coupled with equilibrium
unemployment, the demand shock would lead to more hours, and hence would
boost output. It could even boost investment if the increase in hours is such
that capital becomes relatively scarce. Another way to generate to change how
demand shocks affect the economy would be to relax the perfect information
assumption, or assume heterogeneous beliefs. [0.5 points]

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